Carry Trade Reaches a Tipping Point

The carry trade, in which investors borrow the currencies of countries with low-yielding debt and invest in higher-yielding currencies, is changing and the dollar looks set to benefit.

Policy between the Fed and other big central banks wil redefine the foreign exchange markets. Photo-Associated Presslooks set to benefit.

As more central banks around the world ease monetary policy at the same time as the U.S. Federal Reserve maps out a strategy to exit from monetary stimulus, the balance that has existed between global high yielders and global low yielders over the last few months is changing.

Once popular higher-yielding currencies, such as the Australian dollar, are now falling out of favor as the interest rates they offer decline and the differential with lower-yielding “funding” currencies, such as the Japanese yen, narrows.

As these positions are unwound, at least temporary support for lower yielders could appear and traditional high yielders could find themselves under pressure.

And the shift in expectations of what the Fed will do next should help to put the dollar in a prime position.

This shift in expectations has been quite sudden.

Only a week or so ago the market was still talking about a “soft patch” in the U.S. economic recovery and the Fed itself was admitting that it might have to think about more monetary stimulus.

But this has changed.

U.S. jobs figures have come in consistently better than expected, even retail sales have started to pick up, and the latest talk coming out of the Fed, according to The Wall Street Journal, is that the central bank is ready to start reversing its easy-money policy, albeit gradually.

The reaction to this has been a sharp rally in U.S. Treasury yields as financial markets start taking the view that the next move is for tighter, not easier, monetary policy.

The yield on 10-year Treasurys may be still below the 2.4% level reached early last year but at 1.9% it is up at a six-week high.

And it is this rally that is rattling the carry trades of old.

As Morgan Stanley commented: “The current push higher in U.S. yields has the potential to impact broader currency market dynamics.”

Of course, investors will probably want to see more evidence of a U.S. recovery, more evidence that it is feeding into higher inflation numbers and more evidence that the Fed is set to start winding down its stimulus efforts, known as “tapering”, before pushing carry trades too much further.

But even without higher inflation expectations and without the Fed actually moving to tighten policy, higher U.S. yields are likely to be attractive and add to investors’ interest in the dollar.